FOREIGN EXCHANGE

MARKET
FOREIGN EXCHANGE MARKET

The foreign exchange market (Forex, FX, or currency market) is a

global decentralized or over-the-counter (OTC) market for the trading of currencies.
This market determines foreign exchange rates for every currency. It includes all
aspects of buying, selling and exchanging currencies at current or determined prices.
In terms of trading volume, it is by far the largest market in the world, followed by
the credit market.

The main participants in this market are the larger international

banks. Financial centers around the world function as anchors of trading between a
wide range of multiple types of buyers and sellers around the clock, with the
exception of weekends. Since currencies are always traded in pairs, the foreign
exchange market does not set a currency's absolute value but rather determines its
relative value by setting the market price of one currency if paid for with another. Ex:
US$1 is worth X CAD, or CHF, or JPY, etc.

The foreign exchange market works through financial institutions and

operates on several levels. Behind the scenes, banks turn to a smaller number of
financial firms known as "dealers", who are involved in large quantities of foreign
exchange trading. Most foreign exchange dealers are banks, so this behind-the-
scenes market is sometimes called the "interbank market" (although a few insurance
companies and other kinds of financial firms are involved). Trades between foreign
exchange dealers can be very large, involving hundreds of millions of dollars.
Because of the sovereignty issue when involving two currencies, Forex has little (if
any) supervisory entity regulating its actions.

In a typical foreign exchange transaction, a party purchases some quantity of

one currency by paying with some quantity of another currency.

The foreign exchange market is unique because of the following

characteristics:

-its huge trading volume, representing the largest asset class in the world leading to
high liquidity;
-its geographical dispersion;
-its continuous operation
-the variety of factors that affect exchange rates
-the low margins of relative profit compared with other markets of fixed income; and
-the use of leverage to enhance profit and loss margins and with respect to account
size.

As such, it has been referred to as the market closest to the ideal of perfect
competition, notwithstanding currency intervention by central banks.

MAJOR PARTICIPANTS IN THE FOREX MARKET

INDIVIDUALS – consists of those people who are ready to participate in trading

activities who wish to have financial affairs in the foreign exchange
COMMERCIAL BANKS – back bone for the success of the foreign exchange market.
They serve as the medium of exchange between the buyers and sellers.

CENTRAL BANKS - Central banks hold large currency reserves of their domestic

currency as well as that of important trading partners. Depending on their
reserves, central banks may decide to buy foreign currency or
sell the local currency in order to influence its value.

SPECULATORS – class of traders that have no genuine requirement for foreign

currency. They only buy and sell these currencies with the hope of making a profit
from it.

HEDGERS – primary participants in the futures market. It is any individual or firm

that buys or sells the actual physical commodity

ARBITRAGEURS – traders that take advantage of the price discrepancy in different

markets to make a profit.

BROKERS - Most brokers allow customers to trade in other currencies, including

those of emerging markets. Using a forex broker, a trader opens a trade by buying
a currency pair and closes the trade by selling the same pair

How the Foreign Exchange Market Works

In the retail currency exchange market, a different buying rate and selling rate will
be quoted by money dealers. Most trades are to or from the local currency. The
buying rate is the rate at which money dealers will buy foreign currency, and the
selling rate is the rate at which they will sell the currency. The quoted rates will
incorporate an allowance for a dealer’s margin (or profit) in trading, or else the
margin may be recovered in the form of a commission or in some other way.

Different rates may also be quoted for different kinds of exchanges, such as for
cash (usually notes only), a documentary form (such as traveler’s checks), or
electronic transfers (such as a credit card purchase). There is generally a higher
exchange rate on documentary transactions (such as for traveler’s checks) due to
the additional time and cost of clearing the document, while cash is available for
resale immediately.

FUNCTIONS OF THE FOREIGN EXCHANGE MARKET

The foreign exchange market is merely a part of the money market in the
financial centres. It is a place where foreign moneys are bought and sold. The
buyers and sellers of claim on foreign money and the intermediaries together
constitute a foreign exchange market.

It is not restricted to any given country or a geographical area. Thus, the

foreign exchange market is the market for a national currency (foreign money)
anywhere in the world, as the financial centres of the world are united in a single
market.

IMPORTANT FUNCTIONS OF A FOREX MARKET

1. Transfer Function:
The basic function of the foreign exchange market is to facilitate the
conversion of one currency into another, i.e., to accomplish transfers of purchasing
power between two countries. This transfer of purchasing power is effected through
a variety of credit instruments, such as telegraphic transfers, bank draft and foreign
bills.
In performing the transfer function, the foreign exchange market carries out
payments internationally by clearing debts in both directions simultaneously,
analogous to domestic clearings.

2. Credit Function:
Another function of the foreign exchange market is to provide credit, both
national and international, to promote foreign trade. Obviously, when foreign bills of
exchange are used in international payments, a credit for about 3 months, till their
maturity, is required.

3. Hedging Function:
A third function of the foreign exchange market is to hedge foreign exchange
risks. Hedging means the avoidance of a foreign exchange risk. In a free exchange
market when exchange rate, i. e., the price of one currency in terms of another
currency, change, there may be a gain or loss to the party concerned. Under this
condition, a person or a firm undertakes a great exchange risk if there are huge
amounts of net claims or net liabilities which are to be met in foreign money.

Exchange risk as such should be avoided or reduced. For this the exchange
market provides facilities for hedging anticipated or actual claims or liabilities through
forward contracts in exchange. A forward contract which is normally for three months
is a contract to buy or sell foreign exchange against another currency at some fixed
date in the future at a price agreed upon now.

No money passes at the time of the contract. But the contract makes it
possible to ignore any likely changes in exchange rate. The existence of a forward
market thus makes it possible to hedge an exchange position.

Foreign bills of exchange, telegraphic transfer, bank draft, letter of credit, etc.,
are the important foreign exchange instruments used in the foreign exchange market
to carry out its functions.

FOREIGN EXCHANGE TRANSACTION

A foreign exchange transaction is an agreement between a buyer and a seller

that a fixed amount of one currency will be delivered for some other currency at a
specified rate. The foreign exchange market spans the globe, with currencies trading
somewhere every hour of every business day.

Foreign exchange reserves include foreign banknotes, foreign bank

deposits, foreign treasury bills, and short and long-term foreign government
securities, as well as gold reserves, special drawing rights (SDRs), and International
Monetary Fund (IMF) reserve positions.

The core function of an exchange is to ensure fair and orderly trading and

the efficient dissemination of price information for any securities trading on
that exchange. Exchanges give companies, governments, and other groups a
platform from which to sell securities to the investing public.
NATURE OF FOREIGN EXCHANGE MARKET

The foreign exchange market is the place where money denominated in one
currency is bought and sold with money denominated in another currency. It
provides the physical and institutional structure through which the currency of one
country is exchanged for that of another country, the rate of exchange between
currencies is determined, and foreign exchange transactions are physically
completed.

The primary purpose of this market is to permit transfer of purchasing power

denominated in one currency to another. For example, a Japanese exporter sells
automobiles to a U.S. dealer for dollars, and a U.S. manufacturer sells instruments to
a Japanese Company for yen. The U.S. Company will like to receive payment in
dollar, while the Japanese exporter will want yen.

TYPES OF TRANSACTIONS IN FOREIGN EXCHANGE MARKET

1. SPOT TRANSACTION

The spot transaction is when the buyer and seller of different currencies settle
their payments within two days of the deal. It is the fastest way to exchange the
currencies.

Here, the currencies are exchanged over a two-day period, which means no
contract is signed between the countries. The exchange rate at which the
currencies are exchange is called the Spot Exchange Rate. This rate is often the
prevailing exchange rate. The market in which the spot sale and purchase of
currencies is facilitated is called as a Spot Market.

2. FORWARD TRANSACTION

A forward transaction is a future transaction where the buyer and seller enter
into an agreement of sale and purchase of currency after 90 days of the deal at a
fixed exchange rate on a definite date in the future.

The rate at which the currency is exchanged is called a Forward Exchange

Rate. The market in which the deals for the sale and purchase of currency at some
future date is made is called a Forward Market.

3. FUTURE TRANSACTION

The future transaction are also the forward transactions and deals with the
contracts in the same manner as that of normal forward transactions.
But however, the transactions made in a future contract differs from the transaction
made in the forward contract on the following grounds:
>The forward contracts can be customized on the client’s request, while the
future contracts are standardized such as features, date, and the size of the
contracts is standardized.
>The future contracts can only be traded on the organized exchanges,
while the forward contracts can be traded anywhere depending on the
client’s convenience.
 >No margin is required in case the of the forward contracts, while the
margins are required of all participants and an initial margin is kept as
collateral, so as to establish the future position.

4. SWAP TRANSACTION

The Swap transaction involve a simultaneous borrowing and lending of two

different currencies between two investors. Here one investor borrows the currency
and lends another currency to the second investor. The obligation to repay the
currencies is used as collateral, and the amount is repaid at a forward rate. The
swap contracts allow the investors to utilize the funds in the currency held by him/her
to pay off the obligations denominated in a different currency without suffering a
foreign exchange risk.

5. OPTION TRANSACTION

The foreign exchange option gives an investor the right, but not the obligation
to exchange the currency in one denomination to another at an agreed exchange
rate on a predefined date. An option to buy the currency is called a Call Option,
while the option to sell the currency is called as a Put Option.

SETTLEMENT DATE

Settlement Date is a securities industry term describing the date on which a

trade (bonds, equities, foreign exchange, commodities,etc.) settles. That is, the
actual day on which transfer of cash or assets is completed and is usually a few days
after the trade was done. The number of days between trade date and settlement
date depends on the security and the convention in the market it was traded.

FOREIGN EXCHANGE RATES

An exchange rate is the rate at which one currency will be exchanged for
another. It is also regarded as the value of one country’s currency in relation to
another currency. Aside from factors such as interest rates and inflation,
the currency exchange rate is one of the most important determinants of a country's
relative level of economic health. A higher-valued currency makes a country's
imports less expensive and its exports more expensive in foreign markets.

Haines said: “Exchange rate is the price of the currency of a country can be
exchanged for the number of units of currency of another country”

For example:

An interbank exchange rate of 114 Japanese Yen to the US Dollar means that
¥114 will be exchanged for each US $1 or that US $1 will be exchanged for ¥114. In
this case it is said that the price of a dollar in relation to yen is ¥114, or equivalently
that the price of a yen in relation to dollars is $1/114.

FACTORS influencing EXCHANGE RATES

1. Supply and Demand
As with many market, the forex market is driven by supply and demand:
>If Buyers exceed sellers, prices go up
>If seller outnumber buyers, prices go down
 2. National Economic Performance/ INFLATION RATE – when inflation
increases there will be less demand for local goods (decreased supply of
foreign currency) and more demand for foreign goods (increased demand for
foreign currency)
3. CENTRAL BANK POLICY
4. INTEREST RATE – Whenever there is an increase interest rates in domestic
market there will be increase investment funds causing a decrease in demand
for foreign currency and an increase in supply of foreign currency.
5. TRADE BALANCES- IMPORTS AND EXPORTS
6. Government Budget Deficit/Surplus – the market usually reacts negatively to
widening government budget deficits and positively to narrowing budget
deficits. This will result in change in the value of the country’s currency.
7. Political Conditions – Internal, Regional and international political conditions
and events can have a profound effect on currency market.
8. Economic growth – Stronger economic growth attracts investment funds
causing a decrease in demand for foreign currency and an increase in supply
of foreign currency.
9. Unforeseen events- terrorism and natural disasters
Despite all these, the global forex market is more stable that stock markets;
exchange rates change slowly and by small amounts.
TYPES OF EXCHANGE RATES

1. FIXED & FLOATING

Fixed Exchange Rate is the official rate set by the monetary authorities of the
Governance for one or more currencies. Under floating exchange rate, the value of
the currency is decided by supply and demand factors.

2. DIRECT & INDIRECT

DIRECT METHOD- Under this, a given number of unit of local currency per unit
of foreign currency is quoted. They are designated as direct/certain rates because
the cost of single foreign currency unit can be obtained directly. This is also called
Home Currency Quotation. INDIRECT METHOD- Under this, a given number of
units of foreign currency per unit of local currency is quoted. Indirect quotation is also
called Foreign Currency Quotation.

3. BUYING & SELLING

Exchange Rates are quoted as two way quotes –
• For purchase- or buy is called bid where exchanger is ready to buy a currency
for which quote is made.
• and for sale – or sell is the ask price to exchange currency

4. SPOT AND FORWARD

The delivery under a foreign exchange transaction can be settled in one of the
following ways:
 Ready or cash – to be settled on the same day
 Tom- to be settled on the day next to the date of transaction
 Spot- to be settled on the second working day from the date of contract
 Forward- to be settled at a date farther than the spot date.

5. CROSS CURRENCY RATES

 A cross rate is the currency exchange rates between two currencies when neither
are official currencies of the country in which the exchange rate quote is given.

THEORIES OF EXCHANGE RATE DETERMINATION

Theories which determine the prices of forex rate considering inflation,

interest rate, and elasticity of price, etc.

LONG RUN THEORY

-Theory which predominately take into account the fundamental changes of
economy.
-In here fundamental changes refer to the change which are going to change the
economic performance of the economy.
Types of Theory:

Purchasing Power Parity (PPP)

1. Absolute PPP
2. Relative PPP

Interest Rate Parity (IRP)

1. Covered IRP
2. UnCovered IRP

SHORT RUN THEORY

-Theories are based more on current information or immediate performance of
economic variables.
-This theory tries to take into account the short run factor which may be eliminated in
the long run

MODERN THEORY: DEMAND & SUPPLY

-The most satisfactory explanation is that a free exchange rate tends to be such as
to equate the demand supply of FOREX.
-The intersection of supply curve and demand curve gives the equilibrium price
-Modern Theory also called balance of payments theory of foreign exchange

The Purchasing Power Parity Theory

The purchasing power parity theory enunciates the determination of the rate
of exchange between two inconvertible paper currencies. Although this theory can
be traced back to Wheatley and Ricardo, yet the credit for developing it in a
systematic way has gone to the Swedish economist Gustav Cassel.

This theory states that the equilibrium rate of exchange is determined by the
equality of the purchasing power of two inconvertible paper currencies. It implies that
the rate of exchange between two inconvertible paper currencies is determined by
the internal price levels in two countries.

There are two versions of the purchasing power parity theory:

(i) The Absolute Version:
 If the law of one price to hold good for each and every commodity then the
theory is termed Absolute form of PPP Theory
 This theory describes the link between the spot exchange rate and price
levels at a particular point of time.
(ii) The Relative Version:
 This theory describes the link between the spot exchange rate and price
levels over a period of time.
 According to this theory, changes in spot rates over a period of time reflect
the changes in the price level over the same period in the concerned
economics.
 This theory relaxes three assumptions of PPP; ie Absences of transportation
cost, transaction cost and tariffs.

Interest rate parity theory

The process that ensures that the annualized forward premium or discount
equals the interest rate differential on equivalent securities in two currencies
The basic premise of interest rate parity is that hedged returns from investing in
different currencies should be the same, regardless of their interest rates.
Parity is used by forex traders to find arbitrage opportunities.

ADVANTAGES OF A FOREX MARKET

1. It is already the world’s largest market and it’s still growing quickly
2. It makes extensive use of information technology – making it available to
everyone
3. Traders can profit from both strong and weak economics
4. Traders can place very short-term orders- which are prohibited in some other
markets
5. The market is not regulated
6. Brokerage commissions are very low or non-existent
7. The market is open 24 hrs a day

FORECASTING EXCHANGE RATES

Market participants who use foreign exchange derivatives tend to take

positions based on their expectations of future exchange rates to hedge their future
cash flows denominated in foreign currencies, especially when they expect that they
will be adversely affected by that exposure. Thus, the initial task is to develop a
forecast of specific exchange rates.

a. Technical Forecasting
Technical forecasting involves the use of historical exchange rate data to predict
future values. It is sometimes conducted in a judgemental manner, without statistical
analysis. From a corporate point of view, the use of technical forecasting may be
limited to focus on the near future, which is not very helpful in developing corporate
policies. 

b. Fundamental Forecasting
Fundamental forecasting exercises are based on fundamental relationships
between various economic variables and exchange rates. This implies that all the
theories relating to exchange rate determination could be used to forecast the value
of the exchange rate over subsequent periods of time. This type of analysis is called
fundamental analysis, due to the economic fundamentals that are used in the
forecasting process. Thus, fundamental forecasting is the practice of using
fundamental analysis to predict future exchange rates. This involves looking at all
quantitative and qualitative aspects that might affect exchange rates, including
various macroeconomic indicators and political factors. Critics suggest that the
applicability of fundamental forecasting exercises is relatively limited as some of the
data that should be included in the model is difficult to quantify and as there is a
relatively large degree of uncertainty about our ability to explain past exchange rate
behaviour with these fundamental factors, we should not expect that they would
provide accurate forecasts.

c. Market-based Forecasting
Market indicators could be used to predict the future values for the exchange
rate. For example, if we maintain that the current spot price reflects the future
expected value of the exchange rate, then it could be used as forecast. Alternatively,
when looking to make use of a one-month ahead forecast for the value of the spot
rate, then we could use the one-month forward rate. This type of forecast would be
classified as a market-based forecast.

d. Mixed Forecasting
Some forecasts are superior to the others, but no one knows with certainty which
forecast is going to provide the best result. Therefore, it has been suggested that to
avoid large forecasting errors one should combine the results that are produced by a
number of forecasting techniques. For example, we could make use of a technical, a
fundamental, a market-based forecast, and the currency beta method, and combine
them by taking the average of these forecasts or we could assign different weights to
each to derive the weighted average value for the future spot rate.

FOREIGN EXCHANGE RISK

Foreign exchange risk refers to the losses that an international financial

transaction may incur due to currency fluctuations. Also known as currency risk, FX
risk and exchange-rate risk, it describes the possibility that an investment’s value
may decrease due to changes in the relative value of the involved currencies.
Investors may experience jurisdiction risk in the form of foreign exchange risk.

There are three types of foreign exchange risk:

1. Transaction risk: This is the risk that a company faces when it's buying a
product from a company located in another country. The price of the product
will be denominated in the selling company's currency. If the selling
company's currency were to appreciate versus the buying company's currenc
then the company doing the buying will have to make a larger payment in its
base currency to meet the contracted price.
2. Translation risk: A parent company owning a subsidiary in another country
could face losses when the subsidiary's financial statements, which will be
denominated in that country's currency, have to be translated back to the
parent company's currency.
3. Economic risk: Also called forecast risk, refers to when a company’s market
value is continuously impacted by an unavoidable exposure to currency
fluctuations.